BOND REPORT: Treasury Yields Jump After Fed Signals Support For Another Rate Hike In 2017

Twelve out of 16 of the Fed's interest-rate setting body would like to see another rate increase this year

Treasury prices fell and yields across the board rose on Wednesday after the Federal Reserve's policy statement revealed most of the central bank's rate-setting committee wanted to see another rate increase in 2017, despite tepid inflation data in the past few months.

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The Fed kept its benchmark interest rate unchanged between 1% to 1.25%, but said it would begin its historic wind-down of the central bank's $4.5 trillion balance sheet in October.

Taken together the asset-portfolio reduction and further increases to interest rates are likely to tighten monetary policy, pushing borrowing costs up and encouraging traders to sell existing bonds in anticipation of richer yielding issuance in the future.

The 2-year Treasury note's yield climbed 4 basis points to 1.442%, the highest since Nov. 2008. The 10-year Treasury note yield rose 3.7 basis points to 2.276%, the highest in five weeks, while the 30-year bond yield rose a basis point to 2.821%.

Bond prices move in the opposite direction of yields.

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Twelve out of the 16 FOMC members indicated they expected to deliver a rate increase--the third of the year--by the end of 2017.

Wall Street expectations for a further rate-increase jumped to a 72% probability in December, compared with 56% chance earlier in the session and a 31% likelihood two weeks ago, CME Group data show (http://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html/).

Yet, many U.S. central bankers, including New York Fed President William Dudley (http://www.marketwatch.com/story/feds-dudley-shows-no-signs-of-wavering-from-support-for-december-interest-rate-hike-2017-09-07), have recently acknowledged the past few months of lackluster inflation readings had thrown doubt on the outlook for higher interest rates. In a news conference, Fed Chairwoman Janet Yellen echoed this sentiment saying incoming data would decide the policy path.

Read: Still on course--Fed signals one more rate hike in 2017 (http://www.marketwatch.com/story/still-on-course-fed-signals-one-more-rate-hike-in-2017-2017-09-20)

To support their hawkish stance, Fed officials insisted that labor markets would continue to tighten, allowing inflation to eventually pickup.

"That feeds into their party line to hike rates, as long as we don't have a huge shock in the labor markets," said Victoria Fernandez, managing director of fixed-income investments at Crossmark Global Investments. "They have to hike rates to meet their forecasts, whether they like it or not."

The so-called dot plot, which shows senior Fed officials' forecasts for interest rates, shifted down to 2.8% from 3% for its longer-rate expectations. Although this would suggest a more dovish interpretation to the policy statement, Aaron Kohli, fixed-income strategist for BMO Capital Markets, highlighted the fact that the dot plot forecast for 2017 and 2018 had remained intact, instead of coming down.

Some market participants had anticipated that the policy-setting Federal Open Market Committee would react to the string of weaker-than-expected inflation readings by lowering their estimates of the number of rate increases next year, said Kathy Jones, chief fixed income strategist for the Schwab Center for Financial Research.

The balance-sheet reduction announcement on its own attracted less attention from bond investors as it was telegraphed to a tee. But many are still uncertain what the portfolio reduction means as no central bank has attempted to wind down an expanded balance sheet, a legacy of the battle to stimulate growth in the wake of the financial crisis and 2007-09 recession.

Some have argued the lack of an initial reaction in the bond market reflects the slow and even pace of the expected asset unwind, a process described by Yellen as at its most ideal tantamount to "watching paint dry." But others feel this shows a complacency that ignores how quickly the process could accelerate.

Also read: Why the bond market isn't freaking out from the Fed's shift to quantitative tightening (http://www.marketwatch.com/story/why-the-bond-market-isnt-freaking-out-from-the-feds-shift-to-quantitative-tightening-2017-09-14)

"The first $100 billion of balance-sheet reduction may have little actual effect on the financial system...but, eventually, the cuts in liquidity will bite," wrote Stephen Stanley, chief economist for Amherst Pierpoint Securities.

On the economic data front, existing-home sales in August fell 1.7% (http://www.marketwatch.com/story/existing-home-sales-fall-in-august-for-the-fourth-time-in-five-months-2017-09-20) to an annual pace of 5.35 million, marking the fourth decline in five months. Economists surveyed by MarketWatch had expected a reading of 5.44 million.

Elsewhere, the 10-year German government bond lost 1.5 basis points to 0.440%.